Gas Panic

Much the way the United States consumes more than 24% of the world’s crude oil, it also consumes more than 22% of the world’s natural gas. The critical distinction between the two, however, is that at least for the time being domestic production is capable of meeting the vast majority (84%) of our natural gas needs.

US reserves, which were long static despite increasing demand, have been experiencing healthy growth this decade thanks to the price of natural gas transitioning to a higher trading range. At this higher threshold, price converts previously uneconomic gas fields into exploitable reserves, as is being manifested in the rapid development of, and growing reliance on, so-called unconventional sources—those derived from tight sand and shale formations as well as from coal-bed methane. Today, these unconventional sources have supplanted conventional wells as the primary source of North American natural gas.

From the US perspective, the price of natural gas seems high, and many are wont to dismiss it as an anomaly attendant to the relentless surge in oil prices. But when considered on either an energy-content or a global price basis, North American natural gas is actually extraordinarily cheap. This discrepancy will afford American industry a competitive advantage that appears to be signaling a resurgence in manufacturing. Decreased liquid natural gas (LNG) imports combined with increased domestic natural gas production are driving the boom Texans have longed for, albeit all over North America and in natural gas rather than oil.

However, the boom comes at the cost of a permanent step-up in price as a confluence of trends can only serve to support, if not increase, the price of natural gas going forward. Foremost amongst these drivers are:

the ongoing, albeit slower than anticipated, shift from regional to international natural gas markets made possible by long distance pipeline networks as well as delivery in the form of LNG will eventually lead to something approaching parity in global prices, which can only translate into higher North American prices;

globally, but especially in the US, monetary inflation-driven cost over runs, project delays and shortages of material as well as skilled personnel will continue to exert an upward pressure on the price of energy, especially natural gas;

the production costs of unconventional sources of natural gas cannot tolerate a reversion to the trading range of but a few years ago—there is simply no going back in terms of US prices as reserves become progressively more difficult and expensive to produce;

the cost of new infrastructure to develop these unconventional sources, as well as the cost of restoring the structural integrity of existing infrastructure long neglected by the last post-boom cyclical downturn, will also be reflected in domestic prices;

in both the US and the majority of the Organization for Economic Co-operation and Development (OECD) member states, climate change has become the cause ce`le`bre and natural gas-fired electrical generation has become the default choice espoused by an unlikely coalition of environmentalists, politicians, and industry lobbies, thereby spurring specious demand that will compete with that of emerging nations for limited supply; and

sovereign risk and the threat to free market operations posed by mercantilist intra-national supply agreements is intensifying and will further constrict global supply.

Combined, this portends well for the natural gas industry in North America and Australia for at least the next decade. But as large and variegated as the natural gas industry is, in an era of escalating inflation, political uncertainty compounded by policy blunders, and the reduced availability of credit, certain sectors stand to outperform disproportionately while others will fall victim to the transformations reshaping the industry. To help readers profit from the unfolding gas panic, we have compiled a portfolio of 27 stocks we believe to be positioned both to navigate the financial turbulence we see stretching to the horizon and to profit handsomely in the unstable environment; and as is our practice, none of our recommendations bear significant sovereign risk.

Editor’s Note: The convergence of numerous Emerging Trends Report themes in this paper lands us in the awkward position of potentially boring subscribers by repeating data, details and conclusions presented in previous efforts. In order to alleviate this concern, we have chosen to proceed from the perspective that readers of this report have also read our previous efforts. For those readers who have not, we invite you to visit our website, http://www.emergingtrendsreport.com to download truncated copies of the following reports: “Scrap in the Time of Scarcity,” “Fuelhardy,” “Electrifying Change,” “Nuclear Tide,” and “Coalescence.” All are relevant to the topic at hand, present what we believe to be a wealth of background information and are available free of charge.

Detail 1: “…the door’s open but the ride it ain’t free”

Not surprisingly, the market volatility attendant to a commodity boom in the midst of an ongoing credit crunch has caused dramatic fluctuations in the ratio of the price of fossil fuels to their energy content, or British thermal unit (Btu) value. Variations in the cost of Btu content provoke changes in fuel choice by large energy consumers, such as those in the industrial and utility sectors, which are able to switch fuels to take advantage of the better Btu value. But these historic relationships have been getting increasingly out of whack: in January 2008, in response to notable spikes in demand from Japan and Spain in the latter half of 2007, Liquefied Natural Gas (LNG) prices exceeded $20.00 per million Btu (MMBtu), which at the traditional ratio of 5.8:1 made crude oil seem a bargain at $90 per barrel (bbl); today, $135 bbl crude makes $12.75 US natural gas seem the bargain. So at the risk of belaboring the obvious, only one of three things can happen if the so-called BTU ratio is to revert to some semblance of its historic mean: the price of crude oil comes down significantly, the price of natural gas goes up significantly, or the prices of both converge accordingly.

Although the only certainty regarding the preceding appears to be the continued volatility associated with fossil fuel prices, there is one glaring anomaly in the current global energy picture that has remarkable implications. A few years ago when imported LNG began providing incremental supply during peak demand periods, falling US production from conventional sources combined with rapidly expanding global LNG capacity and abundant foreign reserves made it appear certain that LNG was destined to become a mainstay of US natural gas supply, and the industry responded by building numerous regasification terminals. However, LNG imports by the US have since collapsed despite increasing natural gas demand, taking a few companies’ share prices along with them.

Import Capacity vs. Import Volumes

Source: EIA/NY Times

Unlike crude oil, natural gas has always been difficult to transport—so much so, in fact, that even today an amount equivalent to one-quarter of US consumption, much of it found in the search for oil, is simply vented into the atmosphere or burned off in a practice called flaring by Russia, Nigeria and the Gulf States. For all intents and purposes useless without transport, only natural gas which could reach markets by pipeline was considered viable, which resulted in regional markets with regional pricing. However, the growing spider web of natural gas pipelines and the rapid development and expansion of LNG, which essentially condenses the gas by chilling it to enable large volumes to be transported by purpose-built tankers, are gradually closing the pricing gap and turning natural gas into a global industry; today, in fact, LNG represents 26% of the global trade in natural gas. This is because, according to Jon Chadwick of Shell Gas & Power, “offshore, LNG beats pipeline gas over distances longer than 1500 kilometers. In straightforward onshore terrain, LNG competes favourably with pipeline gas over distances greater than 1800 kilometers. Beyond 4000 kilometers, whatever the terrain, LNG is the better-cost choice.” Importantly, both turn otherwise stranded natural gas into a marketable commodity—making natural gas the only fossil fuel that has been experiencing increasing global reserves.

The collapse of LNG imports to the US is the result of two distinct trends, both of which appear set to continue for the foreseeable future. The first is that while natural gas demand within the OECD is increasing at a healthy 2.6% annual rate, it is nearly three times that much in developing countries, driven largely by the energy intensity attendant to construction booms in basic infrastructure. To put this notion in perspective, consider: according to the International Energy Agency, “the increase in China’s energy demand between 2002 and 2005 was equivalent to Japan’s current annual energy use.”

Japan, the world’s largest consumer of LNG, and major consumers South Korea and Taiwan are now facing intense competition not only from the likes of China, India and Viet Nam but also from increased demand from Europe. In the face of this increased demand, sovereign as well as political issues and LNG gasification plant cost over-runs and delays have been squeezing supply, driving the price of LNG substantially higher than the US market is willing to pay for natural gas simply because it can be produced cheaper domestically. For example, last winter Japan and South Korea had to pay twice the US price for LNG to secure the supply they needed. Consequently, LNG supply that had long been earmarked for the US is now headed to China or elsewhere in Asia (please refer to Section 3 regarding the international situation).

The second trend relating to natural gas price involves the sustainability of US domestic production. At the end of 2007, US fossil fuel reserves were as follows:

Reserve Life Index for coal, gas and oil

Source: BP Statistical Review/UBS

The Reserve Life Index can be increased either by finding new reserves (that is, natural gas that can be recovered economically) or by reclassifying existing resources as reserves, which is a function ofprice.

There is tremendous controversy regarding the extent of recoverable reserves of natural gas remaining in North America. As depicted on the map on the next page, there is little argument about there being substantial natural gas resources remaining but much debate about how much can be reclassified as actual reserves and brought to market.

The paradox that reserves are actually increasing despite the staggering amount of natural gas the US consumes every year, which in 2007 ran to 23 trillion cubic feet (Tcf), up from 21.7 Tcf in 2006, is an example of the alchemy of price at work. Assuming the resource is in place, increasing price increases reserves. For example, depending on the source, until the price of natural gas increased to and steadied above the $3.00-4.50 per thousand cubic feet (Mcf) threshold, widespread exploitation of natural gas trapped in formations with low permeability and porosity, such as tight sand, shale and coal, the so-called unconventional sources, was largely a marginal proposition due to its production cost, for unconventional sources are uniformly labor intensive and technologically demanding.

Source: NRC 2006

Once the higher price range was established, the newly economic reserves were rapidly developed (thereby increasing the light blue share of the pie charts on the map at the expense of black).

When all of the reserves under the established price ceiling have been developed, provided other sources such as LNG or conventional natural gas supply are not made more attractive due to price, this alchemy then transforms the next most accessible resource into reserves in order to meet on-going demand as well as decline from existing fields. This stair-step higher action between the price of natural gas and the cost of producing it from unconventional sources, after being marginal for the four years ending in 2006, appears to have established a new floor in the $7.00-8.00 Mcf range for the time being.

Before continuing and for the sake of clarity, when the ETR refers to a ‘conventional’ well we mean some variation of the classic notion of drilling a vertical well into a pocket of gas that is released forcefully, exhausting itself in perhaps as little as 4 years. In this regard, a conventional well may be thought of rather like a pressure cooker venting a large volume of steam in a relatively short period of time. ‘Unconventional,’ on the other hand, refers to the use of technological means (please refer to section 2) to enable gas to escape from generally stubborn formations in comparatively lower volumes but over vastly longer timeframes, perhaps producing for as many as 50 years. In kitchen parlance then, an unconventional well may be thought of as a tea kettle on low heat whistling steadily as it releases a relatively low volume of steam over a longer period of time before running dry.

Production from conventional natural gas wells in the US is in persistent decline (please refer to the chart below). Further, it is widely agreed that unless major parts of the country presently closed to exploration and development, such as Federal lands, the continental shelves and the arctic, are opened, it is unlikely that large new conventional gas fields will be found; the ‘lower 48’ states represent the most thoroughly perforated real estate on the planet, and the industry perspective is best summed up as ‘if conventional gas fields were there, we would have found them.’

This dearth of new conventional gas fields, along with other factors discussed in the next section, is accelerating the frequency with which the alchemy of price must be repeated in order to make increasingly challenging unconventional sources economic. The good news: there are considerable unconventional reserves remaining to be exploited if we are willing to pay the higher price to recover it, and this is money that largely stays and circulates within our borders. The bad news: pay for it we must because we now rely ever more on these unconventional sources not only to offset declining production from conventional sources but to meet accelerating new demand growth as well. This is clearly demonstrated by the chart on the next page.

Conventional and Unconventional Natural Gas Production

Source: Kuuskraa et al

Over the last decade more than 100,000 unconventional wells have been drilled in the US, with more than 20,000 wells being completed during both 2005 and 2006. Unconventional wells accounted for roughly two-thirds of all the successful wells drilled in the US over that time period and now constitute eight of the ten largest gas fields currently in production. And it is important to note that unconventional production may well actually exceed Energy Information Administration (IEA) estimates, for they have consistently underestimated its performance thus far.

As marvelous and reassuring as all this sounds, as can be seen on the chart on the next page, unconventional sources are not without significant drawbacks, not least being this means the boom underway is driven by the urgency of having to drill more wells costing more money each to produce less natural gas daily per well.

US Natural Gas Well Production

Source: Malone

It can be argued that the situation represents but a numbers game that will balance out over the long term as enough wells are brought on-stream; further, adding such long lived production to the energy mix assures long term supply. However, this largely ignores numerous critical considerations explored in the next section that indicate to the ETR that although the $7-10.00 range could well bring a tremendous amount of natural gas to market, reducing America’s need to import LNG, the stair-step higher approach to creating reserves through the alchemy of price may well develop a momentum of its own and evolve into a Faustian escalator ride to significantly and perpetually higher prices.

Detail 2: “…so let us not talk falsely now, the hour is getting late”

Perhaps the best way to garner some semblance of an understanding of what is transpiring in the global oil and gas markets today, for they are utterly inseparable, is to filter out all of the white noise emanating from the ‘Blame Game’ blaring from a media source near you:

Peak Oil supporters are blaming oil-producing countries for obfuscating and politicians for refusing to act to stave off an impending calamity;

Opportunistic American politicians are blaming Big Oil and accusing them of price gouging—despite the government reaping de facto windfall taxes far in excess of oil companies’ profits;

And everybody is blaming either Middle-Eastern instability or villainous speculators.

This is not to say that these issues are not germane to the discussion, for there is undoubtedly a kernel of truth in each and every one, only that these amount to over-hyped, sensationalist positions that do not offer concrete solutions but merely serve to generate headlines and sound bites appearing to do something while nothing actually gets done other than the price of anything related to fossil fuels drifts higher. Excuse our cynicism, but when it comes to fossil fuels, it has ever been thus: public figures posture in outrage and concern; price settles into a new, higher range which is reflected in the markets; people reconcile themselves to the higher prices and adjust their lifestyles accordingly; and a new crisis comes along to draw our attention elsewhere. It’s the way we live these days.

But if we filter out the noise to concentrate on the signal, what comes through is a long term trend driven by a wide range of compelling issues, of both domestic and foreign origin, that can not be resolved easily or quickly and will therefore serve to support the price of all fossil fuels going forward. This provides us with the opportunity to profit from a clear trend, not fall victim to it; and arguably, this pertains to natural gas most of all.

Consider: the price of oil has been over $120 per barrel for months on end, and today the world’s media is talking about an imminent correction to the $100/bbl range bringing relief. Talk about a pyrrhic victory: that would represent a mere doubling in the price of oil-- or a 50% loss of energy purchasing power in dollar terms, depending on your perspective-- in less than 15 months. And if the price of natural gas were to revert to its historic mean in terms of Btu value, $100 oil translates into $17 natural gas, a mere additional 35% upside from today’s domestic prices but interestingly not a far cry from current global LNG prices.

As touched upon in the previous section, domestic natural gas prices reflect the cost of replacing conventional with unconventional supply, augmented as price allows by LNG supply. The majority of conventional domestic supply projected to come on-stream over the next decade is from deep water and ultra-deep water offshore sources primarily in the Gulf of Mexico, the price of which is escalating in response to the demands imposed by the environment and the technical difficulties involved, not to mention the skyrocketing material and equipment costs. As we go to press, there is not a tight sand, gas shale or coal-bed methane region in North America that is not in play—even those that are either fearfully remote or completely lacking in infrastructure, or both.

The return of the so-called super-majors, notably ExxonMobil and ConocoPhillips, to unconventional production bespeaks both the size of the opportunity and the dearth of conventional alternatives. But this also serves to highlight our contention there will be no significant long term decline in natural gas prices in North America simply due to the expense of such production. The majority of the technologies being employed today were developed more than a decade ago for use in the oil industry and were until recently deemed too expensive to be employed with natural gas, which certainly suggests higher production costs are here to stay. And though experience in their use has led to improved efficiencies in optimizing well spacing and recovery techniques, for example, other considerations promise to more than offset these savings.

Two of the most ominous threats to natural gas price stability actually have very little to do with natural gas per se and everything to do with the historic boom and bust cycles that have prevailed in the oil and gas industry for more than a century. Following the colossal build-out in response to the oil shocks of the 1970’s, supply literally swamped demand, collapsing price, and prompting the longest cyclical downturn in fossil fuel prices since World War II.

For nearly a generation, not just in oil and gas but in virtually every commodity-related industry in North America, companies were so focused on surviving that operational expenses were cut to the bone, and employment and maintenance suffered as a result. Today, the gap between retiring greybeards and young whippersnappers has created both a manpower shortage and an experience void. Oil and gas projects are being delayed or cancelled outright for lack of trained personnel because the technology employed in unconventional wells is expensive and complicated, requiring training and considerable experience to master. The formula extant today that has more wells being drilled at a higher cost each but producing less natural gas per day but with a longer well lifespan indicates that it is and will remain very labor intensive, and many industry experts do not believe we have the rigs and people to meet the challenge. And as the extent of the problem becomes widely recognized, experienced personnel will command top dollar.

Also driving prices higher is the fact that the long postponed infrastructure replacement cycle (‘if it ain’t broke, don’t fix it’) can no longer be avoided. The number of accidents as well as incidence of equipment failure is increasing, as would be expected in any industry in which a large percentage of the equipment still in operation is long beyond its design life. For comparison purposes and because data is lacking regarding the natural gas industry, the average oil pipeline in the US is roughly 50 years old. Jim Mulva, CEO of ConocoPhillips, recently warned American consumers that the country faced potential shortages not from lack of natural gas supply but from lack of pipeline capacity. As it stands, because of transmission constraints, consumers in the northeast sometimes face natural gas prices that are as much as 85% higher than the national average.

This clearly indicates the current oil and gas boom in the US is structural in nature, not cyclical, and portends far more upside for prices than is widely believed. It will take many years and a tremendous amount of money to undo the damage of the last twenty years of infrastructure neglect while simultaneously facilitating a massive build-out to bring new unconventional sources of natural gas on-stream to meet demand. As an example, where the old rule of thumb was that natural gas pipeline construction was roughly one million dollars per mile, consultant Tudor Pickering Holt in May submitted it may be running to four to five millions dollars per mile today.

Contrasted against these manpower and infrastructure price drivers, natural gas has the ‘green credentials’ of releasing roughly 50% less carbon dioxide (CO2) than coal. Consequently demand for electrical generation is clearly trending higher (please refer to the chart on the next page):

Natural Gas Demand for Electrical Generation

Where overall electrical demand growth in the US is running at roughly 2% per year, new natural gas-fired generation ran to nearly 10% in 2007, and it appears likely the trend has legs. Due to the decade-long lead times as well as the wholly uncertain costs associated with building new nuclear base load power plants, and most utilities being reluctant to build new coal-fired plants due to regulatory uncertainty regarding carbon policy, not to mention a coalition of Wall Street investment banks announcing they would not finance such ventures, natural gas has become the default choice for base load electrical generation.

Often overlooked in all the hype surrounding renewable energy is that intermittent energy sources also pose significant load fluctuation hazards to the electrical grid and require more spinning reserves, or instantly available back-up power, than traditional sources, which is further contributing to the demand for natural gas power plants. While it is true that natural gas-fired plants, such as combined cycle gas turbines (CCGT), are the fastest to permit, cheapest and fastest to construct, and provide a return on investment in less time than other forms of primary base load generation, natural gas is also the most expensive fuel for such applications, which is why it has long played more of a role as a supplier of peaking power—and electricity prices are tied to the most expensive molecule, not the cheapest.

With the long overdue and sorely needed upgrade and expansion of the US electrical grid finally gaining traction, we see increased natural gas electrical generation being half of a one-two combination that will clobber retail consumers. However, despite the increased rates, by global standards the rates paid by US industry will remain a bargain. And curiously, in a convergence of ETR themes, we have been picking up clear signs of a remarkable revitalization of US manufacturing driven by the combination of real wage suppression, a cheap dollar, aged but serviceable infrastructure, access to cheap transportation, and most important of all surplus capacity originating in the American heartland. Largely ignored by both coasts and the media, who are understandably preoccupied with the credit crunch and plummeting asset values, as this trend develops the need for US infrastructure of all stripes will increase as well and more Americans will find meaningful employment meeting that demand.

Gas Panic is intended to present an enduring evaluation of this trend and its impact on the North American natural gas market. 60 pages of documented research and analysis explore:

the rapidly evolving shifts in the international Oil & Gas market;

its impact on the OECD in general and North America and Australia in particular;

how this contributes both to the trend in the natural gas markets and to the surprising overarching theme developing in North America;

our investment approach to capitalize on both themes, which includes 27 stock recommendations free of significant sovereign risk as well as sectors both to avoid and to monitor;

our conclusions regarding the long term impact of these two trends; and,